Like most baseball fans, I am shocked by the money going to free agents this off-season. I expected this to be a big year, but these numbers are off-the-chart huge, far higher than I anticipated. Because many of these contracts are long-term deals—Soriano got 8 freakin’ years, which is a totally different problem—I wondered if some anticipated revenue growth would be enough to explain these salaries. Maybe, by the time the contracts expire, the players will have generated value equivalent to the higher revenues the league will generate in the coming years. So, I decided to take a quick look.

I took the 2006 performances of Carlos Lee, Gary Matthews, Juan Pierre, Aramis Ramirez, and Alfonso Soriano, and assumed that these players would perform at the same level for the duration of their contracts (an upwardly biased assumption). I then determined the annual revenue growth rate needed to generate a value equal to the 2006 performance of each player over the course of the contract. For example, I estimate that Soriano generated over $12 million for the Nationals in 2006, far below the $17 million/year average of his contract. But, as revenue rises player performances will grow more valuable. Maybe by the time 2014 rolls around, $17 million won’t seem so expensive.

It turns out that the annual revenue growth needed to justify these contracts is about 10% for all of the players. TEN PERCENT! Heck, even if you assume modest inflation that’s a high growth rate. Now, I can easily buy a year or two of such growth—in fact, revenue did increase by about that much from 2004 to 2005—but this type of growth is not sustainable very high for a large established business over a long period of time. At that rate MLB will be doubling its revenues in about 7 years. So, what is going on?

Hypothesis 1: All teams are plain nuts. (very unlikely)
Hypothesis 2: All teams are estimating on recent high growth as sustainable. (possible, but doubtful)
Hypothesis 3: A few teams are plain nuts or confused by recent growth. (likely, but not the full explanation)
Hypothesis 4: MLB has been making a lot more money than we thought, and for some reason teams are not restraining themselves the way that they have in the past. (hmm…)

I’ve been wondering about some language in the labor deal that settled some past collusion allegations, which occurred in 2002. Supposedly, this is no big deal, just patching up some minor disagreements. The settlement was small, but I wonder if the players gave up their fight because they had reached some agreement that would prevent future collusion, if it did exist. After all, A-Rod and Manny got big contracts in 2001 because owners thought they’d generate enough revenue to cover them. If the owners then figured out a way to shut off the tap, then these deals would stop. And that’s when the black helicopters swoop in…

Hey, this is way over-the-top conspiracy reasoning, but I am really curious as to what is going on here.

Addendum: Other suggested reasons are welcome.

Further Addendum: In the comments, Tangotiger points out that 10% growth in salaries is the historical norm over the past 20 years.

22 Responses “Free Agent Salaries and MLB Revenue Growth”

I believe that one of the reasons it’s happening is because of the huge surplus of great young players. I think we’ve seen a historic level of young talent enter the majors the last two years, and these guys get paid the minimum. This frees up salary dollars for free agents.

So even though these contracts may not be justificable on a marginal revenue basis, there is a greater portion of the “fixed cost/revenue” available to pay free agents.

I would not be suprised one bit to find collusion amongst the owners. They have done it from practically day one of baseball. Whether it was colluding against one of their own, Harry Frazee for example, or against the players. No one believed that there was any collusion in the 1980’s until it was proven in court. Everyone thought the players were paranoid, greedy, jerks. Then we find out the owners had decided not to bid against each other for free agents. Why couldn’t such a thing happen again, especially with a former owner being in the commissioners office?

Why is 10% not sustainable? Payroll has grown at a 10% clip from 1985 to 2005. Also 10% from 1990 to 2005. As high as 9% from 1996 to 2005. While 6% may seem more appropriate, I’d counter that MLBAM money will be enormous. MLBAM is already worth more than the Yankees I’d guess. And one day, possibly within the next few years, MLBAM will be worth 50% of the entire league.

Teams will have lots of money floating around, and, while spending it won’t give them a bigger share of MLBAM, they won’t be able to resist not spending it. They are going to budget spending 55% – 60% of their revenue on payroll, even if 45% makes more sense because of MLBAM-revenue sharing.

You’re right on that Tom. I should have said “very high,” compared to 3% GDP growth, instead of “not sustainable.” I guess I got carried away, must be dizzy from looking at these big numbers. I’ll modify my statement. MLBAM gave the league a huge cash infusion, but I wonder what it’s long-term revenue potential is. Maybe MLB can keep it up for another 20 years, and what a feat that would be. In any event, the MLB is thriving. We’ll see what the future holds.

Additionally, you led me to something that’s potentially more interesting. As you point out, from 1985-2005, the average growth rate in salaries has been about 10%. I had been looking at some more recent numbers. From 2002-2006 (just after the A-Rod/Manny season) the average growth rate in salaries was only 3%, which is more in line with what I expected. But again, it explains why some of these deals are catching us (or at least me) off guard. And, maybe there is something to this collusion thing. Again, these are just pieces.

There might be some of this going on, but I don’t think it’s a big part of the explanation. While the dollars are freed up from younger players, a player’s marginal revenue product is his marginal revenue product. If he only generates $5 million/year in revenue, you don’t pay him more because you can.

In the long run I agree with you, JC. But I don’t think that explains baseball behavior in the short run (and I think that’s true of a lot of businesses). Baseball owners think of budgets in the short run, in which ballplayers are an expense. I think it’s only in the long run that owners tend to view ballplayers as investments that generate revenues.

I also think it’s pretty clear that baseball owners look beyond short-term marginal revenue to franchise valuation. The best example in the current market is the Cubs, who are for sale. The owners of the Cubs must think their franchise is worth more with Soriano in the fold at an outrageous price than without him. IOW, the player contributes more to the franchise value than the cash.

Not to get into a point/counterpoint, but my guess is you don’t quite understand how much money has been freed up by the extraordinary freshman/sophomore class in baseball. I’ve got something about it in the THT Annual. Essentially this group of players contributed 60% more in WSAB than the same group in 2004, about 37% of all WSAB. That frees up a ton of salary budget.

Regarding the Cubs, a bad move by a club for sale? I doubt it. Having been involved in several sales and mergers, businesses are very cognizant of long-term deals when they are up for sale. I think the Trib execs did exactly what they think will boost the franchise value of the Cubs. They may be wrong, but they’re in the middle of selling the franchise right now. They’ve got a better feel for these things than I do.

I understand that MLB has far exceeded expectations with regard to new media revenues (i.e. MLB.com, MLB.tv, video games, etc…) and that those monies, coupled with a new TV contract and now labor peace guaranteed for a few years with the new CBA, has created a bit of a windfall.

There may be money available, but it would be irrational to spend it on free agents that generate less in revenue than the amount paid out. Maybe owners are somewhat altruistic, which is a legitimate argument. I’m more interested in the increasing value of players due to the increased willingness-to-pay for baseball by fans.

I don’t think the Cubs would make a bad move because they are selling. If I implied that, I didn’t mean to. The value of Soriano, positive or negative, will be capitalized into the value of the sale price, so the owners are certainly aware of this. It is possible that the owners are making a sound business decision based on information I’m unaware of, but so far, I can’t rationalize this deal. Maybe there is a principal-agent incentive problem. Maybe I’m just wrong. In my opinion, I think tying up $136 million dollars for eight years in a player with Soriano’s track record is not a smart move. I’m an rational agent/efficient market guy. I’m trying to find a way to rationalize these deals with this exercise.

I agree that teams are not paying for the marginal product. They start off agreeing their budget will be say 55-60% of revenue, allocate what they need for the arb and slave wages, and then the rest is devoted to free agents.

If this means that FA are paid double what they should be, sobeit. Teams work off the technicals far more than on the fundamentals, in the short- and medium-run. There is no long-run, because no money manager (GM) sticks around that long to care.

So are we to assume that baseball GMs are extremely nearsighted to the point that the Angels are willing to tie up 5 years and $50 million with Gary Matthews when all likelihood Andruw Jones will be available next fall? I realize there is a significant chance of not getting Jones, but should we assume that GMs completely disregard future free agents?

I’m just going to copy and paste from an e-mail I sent a couple of days ago. I think it’s a pretty important concept to understand:

I haven’t found anything yet, anything definitive, that is, but based on the work I’ve done so far, it seems to me that people under-estimate the value of a marginal win, largely because of how much it increases team value. For example, in the Yankees’ value grew by $76 million from 2005 to 2006, the Devil Rays’ grew by $33 million. The Yankees won 28 more games in 2005 than the Rays, so that would mean a marginal win is worth about $1.5 million more than we think (which takes it from $2.5-3 million to $4- 4.5 million, which is what teams pay for free agents!).

If you take the next two most extreme teams (in terms of 2005 revenues), the Red Sox and Twins, you find that a marginal win is worth $1.3 million in terms of franchise value, so it looks like we’re in the right neighborhood. Now the issue is that a large market team’s value might grow more even if it does not win more games, so we need to adjust for that (and then there are some other things), but that’s a rough demonstration of what’s going on.

One issue I have with that argument is that I presume the value you refering to is the capital value of the club as reported by Forbes.

Do you have any idea how Forbes creates these numbers? Is through a DCF process, or comps? What expertise does Forbes have here (except doing it for a few years)? They are not a bank or a consulting firm so what to they really know about business valuation?

Now, I could well be wrong and Forbes may have a bunch of experts who are routinely engaged on sport takeovers and therefore their opinions should be well regarded. I just don’t have the information to be able to say whether this is right.

To clarify, the point is also that valuation is an inexact science. In these valuation models an increase in value of 10% is probably within the margin of error of the assumptions. I am sure that the ballpark numbers (no pun intented) are in the right order of magnitude, it is the year on year change that is suspect.

You obviously can’t make any conclusions based on one or two teams. But from the research I’ve done (and again, I’m not done with it, so I can’t say for certain), this phenomena applies to every team. The Forbes evaluations have turned out to be pretty spot-on, and I think that on a league-wide level they do a pretty good job.

Do these values continue to rise independent of inflation and the increased centralized MLB profits? It is counter-intuitive that a 94-win season in 2002 would have any bearing on franchise value in 2007. While it is of course reasonable that a recent winning record drives up a franchise’s value on the market, I have doubts that it is appropriate to treat the relationship between wins and franchise value as, in essence, profit. Do teams like the Braves see a leveling out of this effect, or have they really continued to increase their value linearly independent of inflation, MLBAM, etc.?

I also can’t help but point out that surely the difference in the value of a dollar in New York and Boston from TB and Minneapolis is substantial enough to be taken into consideration. I think you probably would need to adjust for the changes in the buying power of the market before you draw any conclusions on the Forbes data.

Nate Silver of Baseball Prospectus has done a lot of work in this area and he has found that making the playoffs impacts future revenue significantly — given that a 94 win team always makes the playoffs pretty much this will be the case here.

The rationale is that a 94 win team is more likely to be a better team and hence repeats its success. Therefore fans will flock to see more games and TV rights will be more expensive because of that. Nate calculates that it is a 10 year effect.